Hedge Fund Failures

Publication Date: December 2006

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

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Abstract:

The growth of hedge funds -- private, high-risk, unregulated investment pools for wealthy individuals and institutions -- has been a striking development in financial markets. There are now about 8,000 funds with a total of over $1 trillion under management; both figures are roughly 10 times what they were a decade ago. Hedge funds are said to account for 30% of trading volume in U.S. stocks and (at times) even higher proportions in more specialized instruments such as convertible bonds and credit derivatives. Their trades can move markets.

Since hedge fund investment is limited by law to the very wealthy, who are presumed to be capable of understanding the risks and bearing the losses of financial speculation, the traditional view has been that there is no public interest in regulating them. Many still hold this view. However, as their size and presence in the markets has grown, hedge funds have attracted scrutiny from regulators and Congress. Does hedge fund trading now create risk exposure outside the relatively narrow circle of their principals and investors? There are two ways this could happen.

First, the failure of a very large hedge fund, or a number of funds with similar portfolios, could pose risks to banks and other creditors. If hedge funds had to liquidate a large market position quickly, prices could fall sharply, widening the circle of losses. Since markets have limited information about hedge funds, rumors about the solvency of large funds could spread panic when markets were already under stress. The possibility that hedge fund failure might cause other financial dominoes to fall is called systemic risk. The best-known example occurred in 1998, when the Federal Reserve organized a rescue of the Long-Term Capital Management (LTCM) hedge fund, because it judged that default posed an unacceptable risk of disruption to the financial system.

Second, investor protection concerns have emerged as the popularity of hedge fund investment has grown. Hedge funds are open only to "accredited investors," defined as those with over $1 million in assets. In the past, this standard seemed high enough to exclude the small, unsophisticated investors who provide the rationale for government regulation. However, since the $1 million figure includes the value of an individual's residence, rising home prices have lifted many who are not necessarily expert in financial matters over the "accredited" threshold. At the same time, institutional investors like pension funds are placing more of their money in hedge funds, which means that rank-and-file workers, retirees, and others may be unwittingly exposed to hedge fund losses.

This report lists major hedge fund failures since LTCM. Because hedge funds are unregulated and do not file public financial statements, reports of the amount of losses and the reasons for failure are usually second hand and subject to inaccuracies. The list is based on sources CRS considers generally reliable, but there are real limits on the availability of information. For a general discussion of hedge funds, see CRS Report 94-511, Hedge Funds: Should They Be Regulated? by Mark Jickling. This report will be updated as events warrant.